[Federal Register Volume 76, Number 213 (Thursday, November 3, 2011)]
[Proposed Rules]
[Pages 68119-68124]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2011-28531]

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Proposed Rules
                                                Federal Register
________________________________________________________________________

This section of the FEDERAL REGISTER contains notices to the public of
the proposed issuance of rules and regulations. The purpose of these
notices is to give interested persons an opportunity to participate in
the rule making prior to the adoption of the final rules.

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Federal Register / Vol. 76, No. 213 / Thursday, November 3, 2011 /
Proposed Rules

[[Page 68119]]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[REG-146537-06]
RIN 1545-BG08

Income of Foreign Governments and International Organizations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed Income Tax Regulations that
provide guidance relating to the taxation of the income of foreign
governments from investments in the United States under section 892 of
the Internal Revenue Code of 1986 (Code). The regulations will affect
foreign governments that derive income from sources within the United
States.

DATES: Written or electronic comments and requests for a public hearing
must be received by February 1, 2012.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-146537-06), Room
5205, Internal Revenue Service, PO Box 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand-delivered Monday through
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
146537-06), Courier's Desk, Internal Revenue Service, 1111 Constitution
Avenue NW., Washington, DC, or sent electronically, via the Federal
eRulemaking Portal at http://www.regulations.gov (IRS REG-146537-06).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,
David A. Juster, (202) 622-3850 (not a toll-free number); concerning
submission of comments, contact Richard A. Hurst at
Richard.A.Hurst@irscounsel.treas.gov.

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in this notice of proposed
rulemaking have been submitted to the Office of Management and Budget
(OMB) for review and approval under OMB approval number 1545-1053 in
accordance with the Paperwork Reduction Act of 1995 (44 U.S.C.
3507(d)). Comments on the collections of information should be sent to
the Office of Management and Budget, Attn: Desk Officer for the
Department of the Treasury, Office of Information and Regulatory
Affairs, Washington, DC 20503, with copies to the Internal Revenue
Service, Attn: IRS Reports Clearance Officer, SE:CAR:MP:T:T:SP,
Washington, DC 20224. Comments on the collection of information should
be received by January 3, 2012. Comments are specifically requested
concerning:
    Whether the proposed collection of information is necessary for the
proper performance of the functions of the Internal Revenue Service,
including whether the information will have practical utility;
    The accuracy of the estimated burden associated with the proposed
collection of information;
    How the quality, utility, and clarity of the information to be
collected may be enhanced;
    How the burden of complying with the proposed collections of
information may be minimized, including through the application of
automated collection techniques or other forms of information
technology; and
    Estimates of capital or start-up costs and costs of operation,
maintenance, and purchase of services to provide information.
    The collection of information in this proposed regulation is in
Sec. Sec.  1.892-5(a)(2)(ii)(B) and 1.892-5(a)(2)(iv). This information
is required to determine if taxpayers qualify for exemption from tax
under section 892. The collection of information is voluntary to obtain
a benefit. The likely respondents are foreign governments.
    Estimated total annual reporting burden: 975 hours.
    Estimated average annual burden hours per respondent: 5 hours.
    Estimated number of respondents: 195.
    Estimated annual frequency of responses: 1.
    An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless it displays a valid
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    This document contains proposed amendments to 26 CFR part 1 and to
26 CFR part 602. On June 27, 1988, temporary regulations under section
892 (TD 8211, 53 FR 24060) (1988 temporary regulations) with a cross-
reference notice of proposed rulemaking (53 FR 24100) were published in
the Federal Register to provide guidance concerning the taxation of
income of foreign governments and international organizations from
investments in the United States. The proposed regulations contained
herein supplement the cross-referenced notice of proposed rulemaking to
provide additional guidance for determining when a foreign government's
investment income is exempt from U.S. taxation.

Explanation of Provisions

    The Treasury Department and the IRS have recently received numerous
written comments on the 1988 temporary regulations. The proposed
regulations are issued in response to those comments.

Treatment of Controlled Entities

    Section 892 exempts from U.S. income taxation certain qualified
investment income derived by a foreign government. Section 1.892-2T
defines the term foreign government to mean only the integral parts or
controlled entities of a foreign sovereign. The exemption from U.S.
income tax under section 892 does not apply to income (1) Derived from
the conduct of any commercial activity, (2) received by a controlled
commercial entity or received (directly or indirectly) from a
controlled commercial entity, or (3) derived from the disposition of
any interest in a controlled commercial entity. Section 892(a)(2)(B)
defines a controlled commercial entity as an entity owned by the
foreign government that meets certain ownership or control thresholds
and that is engaged in commercial activities anywhere in the

[[Page 68120]]

world. Accordingly, an integral part of a foreign sovereign that
derives income from both qualified investments and from the conduct of
commercial activity is eligible to claim the section 892 exemption with
respect to the income from qualified investments, but not with respect
to the income derived from the conduct of commercial activity. In
contrast, if a controlled entity (as defined in Sec.  1.892-2T(a)(3))
engages in commercial activities anywhere in the world, it is treated
as a controlled commercial entity, and none of its income (including
income from otherwise qualified investments) qualifies for exemption
from tax under section 892. In addition, none of the income derived
from the controlled entity (e.g., dividends), including the portion
attributable to qualified investments of the controlled entity, will be
eligible for the section 892 exemption. Several comments raised
concerns that this so-called ``all or nothing'' rule represents an
unnecessary administrative and operational burden for foreign
governments and a trap for unwary foreign governments that
inadvertently conduct a small level of commercial activity. These
comments have requested that the Treasury Department and the IRS revise
Sec.  1.892-5T(a) to provide for a de minimis exception under which an
entity would not be treated as a controlled commercial entity as a
result of certain inadvertent commercial activity.
    In response to these comments, the proposed regulations at Sec.
1.892-5(a)(2) provide that an entity will not be considered to engage
in commercial activities if it conducts only inadvertent commercial
activity. Commercial activity will be treated as inadvertent commercial
activity only if: (1) The failure to avoid conducting the commercial
activity is reasonable; (2) the commercial activity is promptly cured;
and (3) certain record maintenance requirements are met. However, none
of the income derived from such inadvertent commercial activity will
qualify for exemption from tax under section 892.
    In determining whether an entity's failure to avoid conducting a
particular commercial activity is reasonable, due regard will be given
to the number of commercial activities conducted during the taxable
year, as well as the amount of income earned from, and assets used in,
the conduct of the commercial activity in relationship to the entity's
total income and assets. However, a failure to avoid conducting
commercial activity will not be considered reasonable unless adequate
written policies and operational procedures are in place to monitor the
entity's worldwide activities. The proposed regulations include a safe
harbor at Sec.  1.892-5(a)(2)(ii)(C) under which, provided that there
are adequate written policies and operational procedures in place to
monitor the entity's worldwide activities, the controlled entity's
failure to avoid the conduct of commercial activity during a taxable
year will be considered reasonable if: (1) The value of the assets used
in, or held for use in, the activity does not exceed five percent of
the total value of the assets reflected on the entity's balance sheet
for the taxable year as prepared for financial accounting purposes; and
(2) the income earned by the entity from the commercial activity does
not exceed five percent of the entity's gross income as reflected on
its income statement for the taxable year as prepared for financial
accounting purposes.
    Comments also requested further guidance on the duration of a
determination that an entity is a controlled commercial entity. In
response to these comments, the proposed regulations at Sec.  1.892-
5(a)(3) provide that the determination of whether an entity is a
controlled commercial entity within the meaning of section 892(a)(2)(B)
will be made on an annual basis. Accordingly, an entity will not be
considered a controlled commercial entity for a taxable year solely
because the entity engaged in commercial activities in a prior taxable
year.

Definition of Commercial Activity

    Section 1.892-4T of the 1988 temporary regulations provides rules
for determining whether income is derived from the conduct of a
commercial activity, and specifically identifies certain activities
that are not commercial, including certain investments, trading
activities, cultural events, non-profit activities, and governmental
functions. Several comments have expressed uncertainty about the
applicable U.S. standard for determining when an activity will be
considered a commercial activity, a non-profit activity, or
governmental function for purposes of section 892 and Sec.  1.892-4T.
    Section 1.892-4(d) of the proposed regulations restates the general
rule adopted in the 1988 temporary regulations that, subject to certain
enumerated exceptions, all activities ordinarily conducted for the
current or future production of income or gain are commercial
activities. Section 1.892-4(d) of the proposed regulations further
provides that only the nature of an activity, not the purpose or
motivation for conducting the activity, is determinative of whether the
activity is a commercial activity. This standard also applies for
purposes of determining whether an activity is characterized as a non-
profit activity or governmental function under Sec.  1.892-4T(c)(3) and
(c)(4). In addition, Sec.  1.892-4(d) of the proposed regulations
clarifies the rule in the 1988 temporary regulations by providing that
an activity may be considered a commercial activity even if the
activity does not constitute a trade or business for purposes of
section 162 or does not constitute (or would not constitute if
undertaken in the United States) the conduct of a trade or business in
the United States for purposes of section 864(b).
    Section 1.892-4T(c) lists certain activities that will not be
considered commercial activities. One such activity is investments in
financial instruments, as defined in Sec.  1.892-3T(a)(4), which, if
held in the execution of governmental financial or monetary policy, are
not commercial activities for purposes of section 892. Several comments
have requested that the condition that financial instruments be ``held
in the execution of governmental financial or monetary policy'' be
eliminated to more closely conform the treatment of investments in
financial instruments, including derivatives, with investments in
physical stocks and securities, which under the 1988 temporary
regulations generally are not commercial activities regardless of
whether they are held in the execution of governmental financial or
monetary policy. Section 1.892-4(e)(1)(i) of the proposed regulations
modifies the rules in Sec.  1.892-4T(c)(1)(i) by providing that
investments in financial instruments will not be treated as commercial
activities for purposes of section 892, irrespective of whether such
financial instruments are held in the execution of governmental
financial or monetary policy. In addition, Sec.  1.892-4(e)(1)(ii) of
the proposed regulations expands the existing exception in Sec.  1.892-
4T(c)(1)(ii) from commercial activity for trading of stocks,
securities, and commodities to include financial instruments, without
regard to whether such financial instruments are held in the execution
of governmental financial or monetary policy. These revisions address
only the definition of commercial activity for purposes of determining
whether a government will be considered to derive income from the
conduct of a commercial activity, or whether an entity will be
considered to be engaged in commercial activities. They do not address
whether income from activities

[[Page 68121]]

that are not commercial activities will be exempt from tax under
section 892. Pursuant to Sec.  1.892-3T(a), only income derived from
investments in financial instruments held in the execution of
governmental financial or monetary policy will qualify for exemption
from tax under section 892.
    Comments have requested clarification as to whether an entity that
disposes of a United States real property interest (USRPI) as defined
in section 897(c) will be deemed to be engaged in commercial activities
solely by reason of this disposition. Section 897(a)(1) requires that a
nonresident alien or foreign corporation take into account gain or loss
from the disposition of a USRPI as if the taxpayer were engaged in a
trade or business within the United States during the taxable year and
as if such gain or loss were effectively connected with that trade or
business. The Treasury Department and the IRS believe that an entity
that only holds passive investments and is not otherwise engaged in
commercial activities should not be deemed to be engaged in commercial
activities solely by reason of the operation of section 897(a)(1).
Accordingly, Sec.  1.892-4(e)(1)(iv) of the proposed regulations
provides that a disposition, including a deemed disposition under
section 897(h)(1), of a USRPI, by itself, does not constitute the
conduct of a commercial activity. However, as provided in Sec.  1.892-
3T(a), the income derived from the disposition of the USRPI described
in section 897(c)(1)(A)(i) shall in no event qualify for the exemption
from tax under section 892.
    After the 1988 temporary regulations were published, section
892(a)(2)(A) was amended by the Technical and Miscellaneous Revenue Act
of 1988 (TAMRA), Public Law No. 100-647, 102 Stat. 3342 to provide that
income derived from the disposition of any interest in a controlled
commercial entity does not qualify for the exemption under section 892.
The proposed regulations revised Sec.  1.892-5(a) to reflect the
amendment of section 892 by TAMRA.

Treatment of Partnerships

    Section 1.892-5T(d)(3) provides a general rule that commercial
activities of a partnership are attributable to its general and limited
partners (``partnership attribution rule'') and provides a limited
exception to this rule for partners of publicly traded partnerships
(PTPs). Several comments have requested that the Treasury Department
and the IRS modify the partnership attribution rule to provide that the
activities of a partnership will not be attributed to a foreign
government partner if that government: (i) Holds a minority interest,
as a limited partner, in the partnership; and (ii) has no greater
rights to participate in the management and conduct of the
partnership's business than would a minority shareholder in a
corporation conducting the same activities as the partnership. The
comments assert that the partnership attribution rule causes many
controlled entities of foreign sovereigns to forego making investments
in foreign partnerships or other foreign entities that do not invest in
the United States out of concern that such investments might cause
those controlled entities to be treated as controlled commercial
entities.
    In response to these comments, Sec.  1.892-5(d)(5)(iii) of the
proposed regulations modifies the existing exception to the partnership
attribution rule for PTP interests by providing a more general
exception for limited partnership interests. Under this revised
exception, an entity that is not otherwise engaged in commercial
activities will not be treated as engaged in commercial activities
solely because it holds an interest as a limited partner in a limited
partnership, including a publicly traded partnership that qualifies as
a limited partnership.
    For this purpose, an interest as a limited partner in a limited
partnership is defined as an interest in an entity classified as a
partnership for federal tax purposes if the holder of the interest does
not have rights to participate in the management and conduct of the
partnership's business at any time during the partnership's taxable
year under the law of the jurisdiction in which the partnership is
organized or under the governing agreement. This definition of an
interest as a limited partner in a limited partnership applies solely
for purposes of this exception, and no inference is intended that the
same definition would apply for any other provision of the Code making
or requiring a distinction between a general partner and a limited
partner.
    Although the commercial activity of a limited partnership will not
cause a controlled entity of a foreign sovereign limited partner
meeting the requirements of the exception for limited partnerships to
be engaged in commercial activities, the controlled entity partner's
distributive share of partnership income attributable to such
commercial activity will be considered to be derived from the conduct
of commercial activity, and therefore will not be exempt from taxation
under section 892. Additionally, in the case of a partnership that is a
controlled commercial entity, no part of the foreign government
partner's distributive share of partnership income will qualify for
exemption from tax under section 892.
    Comments also assert that disparity in tax treatment exists under
the temporary regulations regarding foreign government trading activity
described in Sec.  1.892-4T(c)(1)(ii) because trading for a foreign
government's own account does not constitute a commercial activity but
no similar rule applies in the case of trading done by a partnership of
which a foreign government is a partner. The comments note that this
disparity is not generally present in determining whether an activity
is a trade or business within the United States under section 864(b).
See Sec.  1.864-2(c)(2)(i) and (d)(2)(i). In response to these
comments, Sec.  1.892-5(d)(5)(ii) of the proposed regulations provides
that an entity that is not otherwise engaged in commercial activities
will not be considered to be engaged in commercial activities solely
because it is a member of a partnership that effects transactions in
stocks, bonds, other securities, commodities, or financial instruments
for the partnership's own account. However, this exception does not
apply in the case of a partnership that is a dealer in stocks, bonds,
other securities, commodities, or financial instruments. For this
purpose, whether a partnership is a dealer is determined under the
principles of Sec.  1.864-2(c)(2)(iv)(a).

Proposed Effective/Applicability Date

    These regulations are proposed to apply on the date of publication
of the Treasury decision adopting these rules as final regulations in
the Federal Register. For rules applicable to periods prior to the
publication date, see the corresponding provisions in Sec. Sec.  1.892-
4T and 1.892-5T in the 1988 temporary regulations and in Sec.  1.892-
5(a) as issued under TD 9012 (August 1, 2002).

Reliance on Proposed Regulations

    Taxpayers may rely on the proposed regulations until final
regulations are issued.

Special Analyses

    It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required. It has also
been determined that section 553(b) of the Administrative Procedure Act
(5 U.S.C. chapter 5) does not apply to these regulations and because
the proposed regulations do not impose a collection of information on
small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6)
does not apply.

[[Page 68122]]

Pursuant to section 7805(f) of the Code, this notice of proposed
rulemaking has been submitted to the Chief Counsel for Advocacy of the
Small Business Administration for comment on its impact on small
business.

Comments and Requests for Public Hearing

    Before the proposed regulations are adopted as final regulations,
consideration will be given to any written (a signed original and eight
(8) copies) or electronic comments, that are submitted timely to the
IRS. The Treasury Department and the IRS request comments on the
clarity of the proposed regulations and how they can be made easier to
understand. All comments will be available for public inspection and
copying. A public hearing will be scheduled if requested in writing by
any person that timely submits written comments. If a public hearing is
scheduled, notice of the date, time, and place for the public hearing
will be published in the Federal Register.

Drafting Information

    The principal author of these regulations is David A. Juster of the
Office of Associate Chief Counsel (International), within the Office of
Chief Counsel, IRS. Other personnel from the Treasury Department and
the IRS participated in developing the regulations.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 602 are proposed to be amended as
follows:

PART 1--INCOME TAX REGULATIONS

    Paragraph 1. The authority citation for parts 1 and 601 continues
to read in part as follows:

    Authority:  26 U.S.C. 7805 * * *
    Section 1.892-4 also issued under 26 U.S.C. 892(c). * * *

    Par. 2. Section 1.892-4 is added to read as follows:

Sec.  1.892-4  Commercial activities.

    (a) through (c) [Reserved]. For further guidance, see Sec.  1.892-
4T(a) through (c).
    (d) In general. Except as provided in paragraph (e) of this
section, all activities (whether conducted within or outside the United
States) which are ordinarily conducted for the current or future
production of income or gain are commercial activities. Only the nature
of the activity, not the purpose or motivation for conducting the
activity, is determinative of whether the activity is commercial in
character. An activity may be considered a commercial activity even if
such activity does not constitute a trade or business for purposes of
section 162 or does not constitute (or would not constitute if
undertaken in the United States) the conduct of a trade or business in
the United States for purposes of section 864(b).
    (e) Activities that are not commercial--(1) Investments--(i) In
general. Subject to the provisions of paragraphs (e)(1)(ii) and (iii)
of this section, the following are not commercial activities:
investments in stocks, bonds, and other securities (as defined in Sec.
1.892-3T(a)(3)); loans; investments in financial instruments (as
defined in Sec.  1.892-3T(a)(4)); the holding of net leases on real
property; the holding of real property which is not producing income
(other than on its sale or from an investment in net leases on real
property); and the holding of bank deposits in banks. Transferring
securities under a loan agreement which meets the requirements of
section 1058 is an investment for purposes of this paragraph (e)(1)(i).
An activity will not cease to be an investment solely because of the
volume of transactions of that activity or because of other unrelated
activities.
    (ii) Trading. Effecting transactions in stocks, bonds, other
securities (as defined in Sec.  1.892-3T(a)(3)), commodities, or
financial instruments (as defined in Sec.  1.892-3T(a)(4)) for a
foreign government's own account does not constitute a commercial
activity regardless of whether such activity constitutes a trade or
business for purposes of section 162 or constitutes (or would
constitute if undertaken within the United States) the conduct of a
trade or business in the United States for purposes of section 864(b).
Such transactions are not commercial activities regardless of whether
they are effected by the foreign government through its employees or
through a broker, commission agent, custodian, or other independent
agent and regardless of whether or not any such employee or agent has
discretionary authority to make decisions in effecting the
transactions. Such transactions undertaken as a dealer (as determined
under the principles of Sec.  1.864-2(c)(2)(iv)(a)), however,
constitute commercial activity. For purposes of this paragraph
(e)(1)(ii), the term commodities means commodities of a kind
customarily dealt in on an organized commodity exchange but only if the
transaction is of a kind customarily consummated at such place.
    (iii) Banking, financing, etc. Investments (including loans) made
by a banking, financing, or similar business constitute commercial
activities, even if the income derived from such investments is not
considered to be income effectively connected with the active conduct
of a banking, financing, or similar business in the U.S. by reason of
the application of Sec.  1.864-4(c)(5).
    (iv) Disposition of a U.S. real property interest. A disposition
(including a deemed disposition under section 897(h)(1)) of a U.S. real
property interest (as defined in section 897(c)), by itself, does not
constitute the conduct of a commercial activity. As described in Sec.
1.892-3T(a), however, gain derived from a disposition of a U.S. real
property interest defined in section 897(c)(1)(A)(i) will not qualify
for exemption from tax under section 892.
    (2) through (5) [Reserved]. For further guidance, see Sec.  1.892-
4T(c)(2) through (c)(5).
    (f) Effective/applicability date. This section applies on the date
the regulations are published as final regulations in the Federal
Register. See Sec.  1.892-4T for the rules that apply before the date
the regulations are published as final regulations in the Federal
Register.
    Par. 3. Section 1.892-5 is revised to read as follows:

Sec.  1.892-5  Controlled commercial entity.

    (a) In general--(1) General rule and definition of term
``controlled commercial entity''. Under section 892(a)(2)(A)(ii) and
(a)(2)(A)(iii), the exemption generally applicable to a foreign
government (as defined in Sec.  1.892-2T) for income described in Sec.
1.892-3T does not apply to income received by a controlled commercial
entity or received (directly or indirectly) from a controlled
commercial entity, or to income derived from the disposition of any
interest in a controlled commercial entity. For purposes of section 892
and the regulations thereunder, the term entity means and includes a
corporation, a partnership, a trust (including a pension trust
described in Sec.  1.892-2T(c)), and an estate, and the term controlled
commercial entity means any entity (including a controlled entity as
defined in Sec.  1.892-2T(a)(3)) engaged in commercial activities (as
defined in

[[Page 68123]]

Sec. Sec.  1.892-4 and 1.892-4T) (whether conducted within or outside
the United States) if the government--
    (i) Holds (directly or indirectly) any interest in such entity
which (by value or voting power) is 50 percent or more of the total of
such interests in such entity, or
    (ii) Holds (directly or indirectly) any other interest in such
entity which provides the foreign government with effective practical
control of such entity.
    (2) Inadvertent commercial activity--(i) General rule. For purposes
of determining whether an entity is a controlled commercial entity for
purposes of section 892(a)(2)(B) and paragraph (a)(1) of this section,
an entity that conducts only inadvertent commercial activity will not
be considered to be engaged in commercial activities. However, any
income derived from such inadvertent commercial activity will not
qualify for exemption from tax under section 892. Commercial activity
of an entity will be treated as inadvertent commercial activity only
if:
    (A) Failure to avoid conducting the commercial activity is
reasonable as described in paragraph (a)(2)(ii) of this section;
    (B) The commercial activity is promptly cured as described in
paragraph (a)(2)(iii) of this section; and
    (C) The record maintenance requirements described in paragraph
(a)(2)(iv) of this section are met.
    (ii) Reasonable failure to avoid commercial activity--(A) In
general. Subject to paragraphs (a)(2)(ii)(B) and (C) of this section,
whether an entity's failure to prevent its worldwide activities from
resulting in commercial activity is reasonable will be determined in
light of all the facts and circumstances. Due regard will be given to
the number of commercial activities conducted during the taxable year
and in prior taxable years, as well as the amount of income earned
from, and assets used in, the conduct of the commercial activities in
relationship to the entity's total income and assets, respectively. For
purposes of this paragraph (a)(2)(ii)(A) and paragraph (a)(2)(ii)(C) of
this section, where a commercial activity conducted by a partnership is
attributed under paragraph (d)(5)(i) of this section to an entity
owning an interest in the partnership--
    (1) Assets used in the conduct of the commercial activity by the
partnership are treated as assets used in the conduct of commercial
activity by the entity in proportion to the entity's interest in the
partnership; and
    (2) The entity's distributive share of the partnership's income
from the conduct of the commercial activity shall be treated as income
earned by the entity from the conduct of commercial activities.
    (B) Continuing due diligence requirement. A failure to avoid
commercial activity will not be considered reasonable unless there is
continuing due diligence to prevent the entity from engaging in
commercial activities within or outside the United States as evidenced
by having adequate written policies and operational procedures in place
to monitor the entity's worldwide activities. A failure to avoid
commercial activity will not be considered reasonable if the
management-level employees of the entity have not undertaken reasonable
efforts to establish, follow, and enforce such written policies and
operational procedures.
    (C) Safe Harbor. Provided that adequate written policies and
operational procedures are in place to monitor the entity's worldwide
activities as required in paragraph (a)(2)(ii)(B) of this section, the
entity's failure to avoid commercial activity during the taxable year
will be considered reasonable if:
    (1) The value of the assets used in, or held for use in, all
commercial activity does not exceed five percent of the total value of
the assets reflected on the entity's balance sheet for the taxable year
as prepared for financial accounting purposes, and
    (2) The income earned by the entity from commercial activity does
not exceed five percent of the entity's gross income as reflected on
its income statement for the taxable year as prepared for financial
accounting purposes.
    (iii) Cure requirement. A timely cure shall be considered to have
been made if the entity discontinues the conduct of the commercial
activity within 120 days of discovering the commercial activity. For
example, if an entity that holds an interest as a general partner in a
partnership discovers that the partnership is conducting commercial
activity, the entity will satisfy the cure requirement if, within 120
days of discovering the commercial activity, the entity discontinues
the conduct of the activity by divesting itself of its interest in the
partnership (including by transferring its interest in the partnership
to a related entity), or the partnership discontinues its conduct of
commercial activity.
    (iv) Record maintenance. Adequate records of each discovered
commercial activity and the remedial action taken to cure that activity
must be maintained. The records shall be retained so long as the
contents thereof may become material in the administration of section
892.
    (3) Annual determination of controlled commercial entity status. If
an entity described in paragraph (a)(1)(i) or (ii) of this section
engages in commercial activities at any time during a taxable year, the
entity will be considered a controlled commercial entity for the entire
taxable year. An entity not otherwise engaged in commercial activities
during a taxable year will not be considered a controlled commercial
entity for a taxable year even if the entity engaged in commercial
activities in a prior taxable year.
    (b) through (d)(4) [Reserved]. For further guidance, see Sec.
1.892-5T(b) through (d)(4).
    (5) Partnerships--(i) General rule. Except as provided in paragraph
(d)(5)(ii) or (d)(5)(iii) of this section, the commercial activities of
an entity classified as a partnership for federal tax purposes will be
attributable to its partners for purposes of section 892. For example,
if an entity described in paragraph (a)(1)(i) or (ii) of this section
holds an interest as a general partner in a partnership that is engaged
in commercial activities, the partnership's commercial activities will
be attributed to that entity for purposes of determining if the entity
is a controlled commercial entity within the meaning of section
892(a)(2)(B) and paragraph (a) of this section.
    (ii) Trading activity exception. An entity not otherwise engaged in
commercial activities will not be considered to be engaged in
commercial activities solely because the entity is a member of a
partnership (whether domestic or foreign) that effects transactions in
stocks, bonds, other securities (as defined in Sec.  1.892-3T(a)(3)),
commodities (as defined in Sec.  1.892-4(e)(1)(ii)), or financial
instruments (as defined in Sec.  1.892-3T(a)(4)) for the partnership's
own account or solely because an employee of such partnership, or a
broker, commission agent, custodian, or other agent, pursuant to
discretionary authority granted by such partnership, effects such
transactions for the account of the partnership. This exception shall
not apply to any member in the case of a partnership that is a dealer
in stocks, bonds, other securities, commodities, or financial
instruments, as determined under the principles of Sec.  1.864-
2(c)(2)(iv)(a).
    (iii) Limited partner exception--(A) General rule. An entity that
is not otherwise engaged in commercial activities (including, for
example, performing services for a partnership as

[[Page 68124]]

described in section 707(a) or section 707(c)) will not be deemed to be
engaged in commercial activities solely because it holds an interest as
a limited partner in a limited partnership. Nevertheless, pursuant to
sections 875, 882, and 892(a)(2)(A)(i), a foreign government member's
distributive share of partnership income will not be exempt from
taxation under section 892 to the extent that the partnership derived
such income from the conduct of a commercial activity. For example,
where a controlled entity described in Sec.  1.892-2T(a)(3) that is not
otherwise engaged in commercial activities holds an interest as a
limited partner in a limited partnership that is a dealer in stocks,
bonds, other securities, commodities, or financial instruments in the
United States, although the controlled entity partner will not be
deemed to be engaged in commercial activities solely because of its
interest in the limited partnership, its distributive share of
partnership income derived from the partnership's activity as a dealer
will not be exempt from tax under section 892 because it was derived
from the conduct of a commercial activity.
    (B) Interest as a limited partner in a limited partnership. Solely
for purposes of paragraph (d)(5)(iii) of this section, an interest in
an entity classified as a partnership for federal tax purposes shall be
treated as an interest as a limited partner in a limited partnership if
the holder of such interest does not have rights to participate in the
management and conduct of the partnership's business at any time during
the partnership's taxable year under the law of the jurisdiction in
which the partnership is organized or under the governing agreement.
Rights to participate in the management and conduct of a partnership's
business do not include consent rights in the case of extraordinary
events such as admission or expulsion of a general or limited partner,
amendment of the partnership agreement, dissolution of the partnership,
disposition of all or substantially all of the partnership's property
outside of the ordinary course of the partnership's activities, merger,
or conversion.
    (iv) Illustration. The following example illustrates the
application of this paragraph (d)(5):

    Example 1. K, a controlled entity of a foreign sovereign, has
investments in various stocks and bonds of United States
corporations and in a 20% interest in Opco, a limited liability
company that is classified as a partnership for federal tax
purposes. Under the governing agreement of Opco, K has the authority
to participate in the management and conduct of Opco's business.
Opco has investments in various stocks and bonds of United States
corporations and also owns and manages an office building in New
York. Because K has authority to participate in the management and
conduct of Opco's business, its interest in Opco is not a limited
partner interest. Therefore, K will be deemed to be engaged in
commercial activities because of attribution of Opco's commercial
activity, even if K does not actually make management decisions with
regard to Opco's commercial activity, the operation of the office
building. Accordingly, K is a controlled commercial entity, and all
of its income, including its distributive share of partnership
income from its interest in Opco and its income from the stocks and
bonds it owns directly, will not be exempt from tax under section
892.
    Example 2. The facts are the same as in Example 1, except that
Opco has hired a real estate management firm to lease offices and
manage the office building. Notwithstanding the fact that an
independent contractor is performing the activities, Opco will still
be deemed to be engaged in commercial activities. Accordingly, K is
a controlled commercial entity, and all of its income, including its
distributive share of partnership income from its interest in Opco
and its income from the stocks and bonds it owns directly, will not
be exempt from tax under section 892.
    Example 3. The facts are the same as in Example 1, except that K
is a member that has no right to participate in the management and
conduct of Opco's business. Assume further that K is not otherwise
engaged in commercial activities. Under paragraph (d)(5)(iii) of
this section, Opco's commercial activities will not be attributed to
K. Accordingly, K will not be a controlled commercial entity, and
its income derived from the stocks and bonds it owns directly and
the portion of its distributive share of partnership income from its
interest in Opco that is derived from stocks and bonds will be
exempt from tax under section 892. The portion of K's distributive
share of partnership income from its interest in Opco that is
derived from the operation of the office building will not be exempt
from tax under section 892 and Sec.  1.892-3T(a)(1).

    (e) Effective/applicability date. This section applies on the date
these regulations are published as final regulations in the Federal
Register. See Sec.  1.892-5(a) as issued under TD 9012 (August 1, 2002)
for rules that apply on or after January 14, 2002, and before the date
these regulations are published as final regulations in the Federal
Register. See Sec.  1.892-5T(a) for rules that apply before January 14,
2002, and Sec.  1.892-5T(b) through (d) for rules that apply before the
date these regulations are published as final regulations in the
Federal Register.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

    Par. 4. The authority for part 602 continues to read as follows:

    Authority:  26 U.S.C. 7805.

    Par. 5. In Sec.  602.101, paragraph (b) is amended by adding an
entry to the table in numerical order to read as follows:

Sec.  602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                            Current OMB
   CFR part or section where identified and described       Control No.
------------------------------------------------------------------------

                                * * * * *
1.892-5.................................................       1545-1053

                                * * * * *
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 Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2011-28531 Filed 11-2-11; 8:45 am]
BILLING CODE 4830-01-P